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Markets left unnerved by China puzzle

In its twice-yearly economic outlook, published in June, the OECD noted that there were “a number of extraordinary risks” which could potentially have big effects on the world economy writes Oliver Mangan Chief Economist at AIB.

It warned in particular about signs of excesses in financial markets stemming from the side-effects of ultra-expansionary monetary policies in recent years.

The OECD pointed to negative bond yields and very tight credit spreads, as suggesting an “extreme pricing” of this asset class. It noted that equity markets had reached record levels and challenging valuations in many countries. It warned that an abrupt correction of these excesses could disrupt financial markets and have considerable negative effects on the real economy.

The OECD also set out some adverse scenarios that could have sizeable implications for the global economy.

One of these relates to the slowdown in the Chinese economy. The OECD says that there is a risk that this could lead to widespread bankruptcies given the rapid credit growth in recent years, with a resultant negative feedback loop between the real economy and financial sector.

“A severe downturn in China would add to global deflationary pressures and have negative effects on economies and financial markets elsewhere”.

Indeed, developments in China have become a key driver of global financial markets in recent weeks. First, global markets were unnerved by the sharp falls on Chinese stock markets.

These falls look to have all the hallmarks of a bubble bursting after the very big gains made over the last 12 months. Then, a surprise devaluation of the Chinese currency last week sent shockwaves through global markets. The move was not that big, with the currency declining by around 3%. However, it was enough to trigger sharp falls in stock markets, a flight into safe-haven bond markets, and significant moves on foreign-exchange markets.

Recent events validate the concerns of the OECD and link two key risks that it identified, namely how developments in China can impact what appear to be nervous and vulnerable financial markets. China is in the process of liberalising and restructuring its economy but it is proving difficult to do in an orderly fashion, and in a way that avoids asset bubbles. There has been an explosion in credit in recent years and a sharp rise in the stock market, even though the economy is experiencing a marked slowdown in growth.

Meanwhile, the currency is linked to the dollar, which has risen sharply in the past year. Thus, China has suffered a marked loss of competitiveness, especially against other export-orientated Asian economies. Export growth has slumped. It is little wonder then that China has started to devalue its currency.

However, the Chinese authorities are stressing that this is the start of a process to allow greater exchange-rate flexibility via loosening the informal peg to the dollar and letting market forces have a greater say in determining the exchange rate.

"The concern for financial markets is that this could signal the beginning of a marked and prolonged depreciation of China’s exchange rate".

This would increase the risk of a so-called currency war, as other countries might follow suit. Meanwhile, China is also a major trading nation and a weakening currency risks exporting deflation to other countries that are already trying to counteract very weak inflationary pressures via extremely loose monetary policies.

The Chinese authorities, though, are still interventionists and have stepped in to calm forex markets, just as they took measures to stabilise falling stock markets in recent weeks. They have indicated that there are no grounds for a persistent deprecation of the currency. China also intervened in support of the currency late last week, which helped the exchange rate to stabilise.

Recent events highlight that China is now an important influence on what are quite nervous financial markets. Thus, it bears close watching.

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